On thin ice?

Hungary's prime minister is in full gear. With declining popularity and approval ratings he is convinced that it is due to his government's inability to make people understand how well they are treated. Instead they believe in the lies of the opposition. As a result Viktor Orbán appears everywhere, gives interviews (even to reporters earlier exiled to remote corners of the public media) and engages the opposition in the parliament. (Contrary to the British custom there is no informal obligation of the premier to participate on Prime Minister's Questions every week.) Additionally he visits friendly societies, in order to clarify his program for faithful followers. 

Aside from the obvious ominous signs - what to expect from people supposedly belonging to the country's business elite who are listening to Orbán's contradictio in adiecto statements without objection, moreover, taking it with applause - the prime minister made yesterday an interesting comment in one of these circles. He referred to that although it is almost impossible to introduce fixed exchange rate it is worth to contemplate the possibility. 

Given the self-proclaimed and proudly borne "unorthodox" nature of the economic policy of the government, such a hint is not necessarily as meaningless as one would be inclined to take it. There is at least one recent example that a country managed to regain competitiveness and growth with a set of measures including capital - and implicitly exchange rate - controls. Paul Krugman gladly compares the example of Iceland as a country that took a more traditional devaluation focused IMF approach in the aftermath of its crisis to the European countries taking the internal devaluation path. Iceland is an example for a country's potential to convince the IMF  that act of its own design can serve the common aim of returning to growth just as well as the IMF's proposals. According to the latest IMF report on Iceland the government insisted on capital controls in order to make devaluation (and implicitly inflating away debt) easier with pre-empting capital flight.

In the light of Iceland's performance, much praised by the IMF, even the idea that Hungary's leaders are contemplating something similar cannot be written off easily. However, some caveats should be made here concerning the viability of a possible change of strategy. Firstly, Iceland started negotiations with the EU on its accession simultaneously with its IMF program. On the one hand it means a strong pledge that capital controls and exchange rate manipulation will remain temporary, on the other hand it was free from the EU rules, something not given for Hungary, part of a joined EU-IMF credit program. It is hard to see in Hungary’s case how EU law can be eliminated, even if it allows for reintroduction of capital controls in case of economic danger. Secondly, Hungary is still following the path of classic austerity – despite the government’s insistence on the opposite –, it is “on the Greek road”, as Orbán likes to formulate. Even if it is possible to change track, the austerity already has forced its citizens to deplete their reserves, it has not strengthened its banking system (as Iceland did), rather weakened it in the last year, and the typical neo-liberal reforms (for example on the labour market) proudly passed in Parliament yesterday do not suggest the government’s willingness to take an alternative route in order to share the burdens of the crisis more fairly. Thirdly, and this point is knit the former, Orbán has a distorted vision of Hungarian society, impeding him to realize policies strengthening equality. Yesterday he also announced that his policies are aimed at strengthening the middle class. However, the latest income statistic of the Statistical Office showed that people with a monthly per capita net income of 130000 HUF (400 EUR, equivalent of 200000 HUF gross wage) in 2010 belonged to the top income decile. Fidesz’s new flat-tax in 2011 meant a tax raise for everyone with a gross wage under 290000 HUF. One can safely guess that Orbán’s policy – however strongly he is convinced of the opposite – benefits only 4-5% of the population, and certainly not the middle class, only the elite. And last, but not least, a sudden change of track would not only need approval from Hungary’s creditors (something certainly not happening without clearly formulated and well founded strategy), but a bit more capacity to act than the government has shown until today.

Disorderly devaluation?

The saga of the conversion of fx-loans in Hungary goes on. According to a report at the Hungarian website origo.hu the government's main aim is to regain freedom of exchange rate determination and practically carry out a devaluation of the forint, without hurting households with fx-loans. As I'm no friend of this government I'm sceptical a bit, no government politician or supporter used this argumentation until today. However, if it is true it is just an even stronger proof of the incompetence of the government.

I know that I was arguing – not that it would matter the slightest – on behalf of external devaluation, therefore to declare a seemingly identical argumentation could seem paradox. Nonetheless, it is hard to treat the government's proposal as fulfilling the three necessary preconditions of a successful devaluation through the conversion of fx-loans. Any attempt should be comprehensive in its extent, prompt in its execution and orderly regarding the covering of losses and managing the inevitable risks. In this case none of the above preconditions exists.

The volume of fx-loans is around 1 million households. The ration of non-performing loans is around 10%. The proposal of the government intends to cover only 300 000 at best, so, the remaining 700 000 would still make a very significant electoral base not to let the forint devalue. And this is the maximal number the government claims will have an opportunity to make the conversion. The Minister of National Economy allegedly argued that only 50 or 100 billion HUF loss will be incurred to the banks, a sum that gives only about 75 000 existing loans converted. Hardly a reduction enabling the government to devalue.

Neither is the proposal prompt enough to make a sufficient reduction for a quick devaluation. Although the prime minister told yesterday that only a limited time frame would be allowed to the debtors to make the conversion (a solution with many – albeit very different – risks), this evening the reports states that the possibility will be open indefinitely. So, even with the compulsory lending of forint based loans prescribed for the banks the process would be slow (given the practical and procedural necessities, finding the suitable new loan, preparing the documentation etc.) and without it it will only be a cherry picking of the better debtors. Meanwhile everyone will avoid the not so promising clients, effectively reducing the number of conversions and therefore postponing the restoration of freedom of exchange rate manipulation. With the process underway for months or probably even for years the economy can not have the boost hoped from the devaluation.

It is again hardly an orderly solution. Although the distribution of the losses is clearly settled at least for the time being* nothing else seems to be in place to impede the dangerous process induced by the conversion. First of all there could be a long period of risen demand for forint that will inevitably lead to higher interest rates, while the exchange rate will be depressed (but probably not depressed enough to lift the exports significantly) to compel the National Bank to raise its policy rate and simultaneously inflating the country's foreign currency denominated sovereign debt. Even at the present rate of 286-287 forint for one euro the debt grew with 800 billion forint, 26+ of the amount the government reduced it back in summer. It would effectively mean the end of the debt reduction course, up to this moment the main objective of government policy.**

Beyond the practical issues the new strategy (external devaluation) is the third one in 16 months. Initially there was an attempt for a stimulus through tax cuts that almost immediately failed due to policy constraints. The EU forbade any deviation form the agreed deficit target of 3,8% of GDP. During the autumn the government made an experiment with classic austerity and tax cuts, but the budget collapsed already in January, leading to the very typical austerity program (internal devaluation), the Széll Kálmán plan and the primary objective of forced and fast debt reduction. And now the government turned around again, this time opting for external devaluation. Albeit not in a very sensitive way. (It is worth to take a look at what happened in Iceland, where – with the assistance of the IMF – a consolidation program based on external devaluation was carried out successfully. It needed far more and far stronger cooperation and effort than the Hungarian government envisages.) And not only the sudden and unexpected turns and twists speak fro themselves, there are a lot of contradiction between these strategies. Austerity is the opposite of the stimulus, while external and internal devaluations are hardly reconcilable and the former will initially raise the debt to GDP ratio. A sensitive mixture of these approaches would still be possible (especially of the first and the third), but it would need a more complex and sensible approach, one that calculates with every possible effect and takes into account every potential risk. Unfortunately the only economic quality the government seems to possesses is a very high marginal propensity for gambling.

* However, the prime minister admitted yesterday that the EU Court would most probably declare the move illegal, order compensation and fine Hungary, but he was eager to assure the people that they do not need to fear, the state will take this burden.

** There are a numerous other risks. For example the conversion means the liquidation of Hungarian assets and payment of huge sums to foreign creditors. Reducing national wealth and handing it over to foreigners, a reduction of the capital and with it the possible base of investment, and obviously will have a negative impact on the current account.

Pride over not being prejudiced

Ok, it was a safe guess. Nothing specific and new in Orbán's speech. Even though I have to admit, even my guess was too optimistic: Orbán didn't even announced anything specific regarding unemployment benefits. Anyway, I'm proud as clearly I was among the few expecting what really happened.

Playing Cassandra, resolving cognitive dissonance and on the importance of not investing too much emotional and intellectual capital in expectations

As I try to take a distance from politics in a stricter sense it could mean that in less troubled times I remain silent. My intention is not to comment on everything happening in Hungary or in ECE, especially not when someone else is perofrming it with more expertise and in line with my opinion, rather to give my ideas when I feel I can express thoughts and ideas less prevalent in the public discussion. (Even if this blog is clearly not part of any kind of public discussion, just a variety of a diary or a notebook.) Furtherome, many occurences in the politics are connected to the crisis only indirectly. Although the electoral success of Fidesz in Hungary, their two-thirds majority enabling them to pass a new constitution and change the basic laws of Hungary according to their will, was not independent from the economic crisis and the populations distaste for and discontent with the Socialists and asuterity, the concept according to they are acting is their very own, rooted in their nationalist ideology what is not a reaction to the crisis. Therefore, although I can offer some thoughts on this problem it is only tangentially part of this blog. Nonetheless, the "war of economic independence" or "economic war of independence" as Fidesz labelled its economic policy in the summer that is part of this broder effort of reshaping the country, reached its next phase this Feburary, after the quasi-nationalization the compulsory private pension funds. The Fidesz now has its own budget, not one they can pretend to have no responsibility for and they acquired enough room for manoeuvre with the partial default and forced natioinalization to come up with their own and original ideas.

Some of the important constraints remained, from the EU with the deficit target under 3%, and from the broader environment as the crisis still looms over Europe. (During the Irish crisis Hungary was significantly affected.) But the government now tries to pre-empt negative reaction and contributed to the growing expecatations regarding a fresh refrom package due in February, at aboput 600-660 billion HUF. The story offers an interesting experience of human behavior and psychology, its failings in a supposedly rational and competitive environment. Especially as it is not the first occasion we can observe an almost identical chain of action and reaction. The sequence is always built on communication according to the taste, expectations and desire of the so-called analysts (or in its impersonal form the markets), a sudden eruption of enthusiatsic love for the government, even more communication and more active emanations of this strengthening love and... Well, in the earlier cases the end was always disappointment but it is clearly not a hindrance of the renewed passionate realtionship. Anyway, and this is where I dare to take Cassandra's role and robes, I would be surprised to see a different outcome this time, as the facts and the stark inner contradictions of what the government suggests and the analysts accept as a new, profound reform agenda are pointing to the opposite what the markets are expecting and waiting for. But this revived love-story is telling in itself.

It began already in December, when - even before the budget was passed - the government announced they will prepare and introduce a reform package in Februay. Common sense would have warned everyone as the least normal course of events is to make a budget with huge efforts, bring it to the parliament, proceed with it with energy and determination only to abandon it after one and a half month. Is this the way governments work? - could have asked everyone. But, instead, it caused jubilation and was taken as a sign that the Fidesz was brought back to its senses and at last they admitted the necessity to come up with structural changes bringing budget spending under control in the mid- and long term. Soon the opening moves of this subtle chess play were made, firstly György Matolcsy and later Viktor Orbán himself - in an interview with Wall Street Journal - told that his government will ensure the state pension fund will not spend more than it recives in the form of social contributions (although the ministry made it clear already in November that it means transfering disability pensions to a separate fund financed from the budget), and announce cuts concerning subvention of medicines, the social services for unemployed and the public transportation system. They even mentioned the sum of 100-100 billion HUF in case of the former two and 50 billion in the case of the latter. As these are the pet targets of every analyst who are reluctant to admit that the structural problems in Hungary can not be solved by simply cutting budget spending in some sectors it was well received and generated a wide-spread belief in the coming of a substantial reform package in mid-February. Neither an easy reality check - asking whether it is possible to cut 100 billion from these funds, both not higher than 340 billion per year while unemployment is well over 10% - nor Fidesz politician's instistence on not doing harm to the population and tampering with their benefits could have deterred analysts from their firm conviction that soon something important will happen. Optimism prevailed even after the first reports on the process of the preparation surfaced, showing that the government is still in the phase of brainstoriming in early Februray. (At that moment the different ministries still collected their ideas independently from each other and they had to put them forward to Matolcsy and Orbán, who are entitled to the final choice.) Optimism was not shaken by the emergence of other details - later admitted by Matolcsy - , suggesting that the plan is not to cut 600 billion in 2011 - an earlier assumption of the markets - but making a cosmetic surgery in this year and delivering some more substantial budget correction in 2012 and 2013. (A few days later the plan turned out to be to begin savings in 2013!) Furthermore, as the process of the planning was in delay the announcement was postponed. Originally the promise was a package published in mid-February. In January it was modified, mid-February became the date when the government could discuss it in first readingand the date of the announcement was established at 28 Februray. In early February the new informations suggested even more delay.

Nevertheless, analysts were very excited at the beginning of this month and expected Viktor Orbán to share important elements of the package with the public in his so-called "state of the country" speech, due on 7 February. As Orbán held a very banal speech, composed of proverbs and self-styled popular sayings analysts, the markets did not show dispair or at least some surprise, they predicted that Orbán will make the whole package public on 14 February, in the parliament, and expetced the Fidesz caucus to discuss it between 9 and 11 February. The latter obviously did not happen, but expectations remained.

However, as there seem to exist no coherent package in the moment, the ideas during the long barainstorming more and more turned towards raising new revenues instead of planning the reforms eagerly awaited it would be astonishing to hear something really significant, different from Orbáns 29 points and the economic plan implemented in October - with the quasi-nationalization of the pension funds. Something certainly will be announced, probably pointing out some directions vaguely, packed in the banal terms of the renwal of the country and it is also probable that cutting unemplyment benefits will be one of the few explicit measures. But it will fall short of any kind of reform and will be very far from the expectations driving the markets to extasy in the last few weeks. There are at least three reasons to expect this outcome. Firstly, Fidesz is aiming at a renewal and reorganization of the nation in its own, nationalist terms. What they try to realize is not some cost-effective restructuring of sub-systems based on thorough consideration of existing models and good practices, but the only model that would express the substance and spirit of the Hungarian nation. It is quite different in the sense that the plans are based on a set of speculative assumptions, but they assume that no constraints of costs may impede its realization. (Exemplified by Orbán, who told the Fidesz caucus, that even if people are right that the governments plans for the public instruction system will cost more than at present, it is the responsibility of the economic minister to find the necessary resources, and not the secretary of state for education to adjust plans to budget constraints as the plans are pointing to the right direction.) Such approach also means that fields analysts consider important in the reforms could be of secondary importance for the government, leading to their neglectment, while other sub-systems - like education - won't be restructured according to the criteria analysts are expecting to direct the changes. Secondly, Fidesz clearly wants to avoid confronting any significant electoral group and as long as they can implement measures that at least seemingly do not affect the people - like the so-called crisis-taxes - they will opt for thes. It is hard to expect major changes in the funding of the public transportation system if it would mean rising costs for the population - for example elimination or curtailing of existing benefits for students, children under 6 or people over 65. The whole brainstorming approach and the continous delay of the announcment is exactly because of this reluctance. According to the information leaked, the apparatus was always very effective in bringing new ideas of new revenues and not quite successful in outlining cost-cutting measures. Thirdly, the present structure of the government and its personal composition with a lot of inexperienced and not quite bright party hacks occupying key positions in ministries consisting concurring departments without a minimum of internal coordination and with a minister responsible for economics ad budget who only trusts in a very limited number of people is an obstacle in the way of preparing a coherent plan, assessing every proposed measure in the context of the state as a public institution and an instrument to deliver public good the most effective way - apart from its assessment in the light of Fidesz's nationalist ideology.

I do not realy want to contemplate the question why analysts again swallowed the bait. Probably they invested too much emotional and intellectual capital in their belief of Fidesz's rationality and willingness to go down the way they expected and at the end they could not disengage. However, it is of some use, at least at a personal level. For a while I had to feel guilt as I was crying with the pack of analysts whom I had criticized earlier. Now it is a chance to detach myself and again point out their failings. Vanity and arrogance as it may be, but reassuring because it restores a part of my identity. :) It resolves this particular form of cognitive dissonance.

Hungary and sovereign default

It's almost official: the government's ingenious plan is to nationalize compulsory private pension savings and spend it on current budget expenses (pensions) and debt reduction. They hope it will enable them to survive without major restructuring and action until the tax cuts will bring 7% GDP growth. (Actually many expressed doubts, how realistic this expectation could be. Some calculate that 8-10% growth would only fill the holes of the budget from 2013.) Anyhow, the government expects 90% of the mambers of such private pension schemes will return to the state run, pay-as-you-go system, eventrually transferring their portfolio to the state. The delicacy of the issue: it is nothing else than default on a part of the debt and restructuring.

Private pensions savings, although compulsory, are private property. They hold about 2800 billion HUF savings in sovereign bonds (circa 1300 billion) and other assets, mainly stocks and investment funds. It means at around 5% of the GDP is in the hands of these private as government issued bonds. As soon as they transfer it to the government they will be rewarded with a promise of a state pension and their portfolio transformed into state property. Obviously the state will never be obliged to redeem them, it will reduce the debt. It is not a straightforward way of default and debt restructuring, but in its essence it is nothing else. Government liabilities at private debtors are declared void and exchanged to another type of government liablity. At the moment it is - nominally - voluntary. However, the pirme minsiter expressed his firm conviction that as much as 90% ot the members of private pensions schemes will choose the satte run system in two months time. As this number is highly unrealistic on a voluntary basis one could expect legislation making it compulsory, transforming the process in a confiscation. Especially in the light of Fidesz's willingness to reduce the jurisdiction and competenc eof the Constitutional Court, barring it from judging the constitutionality of economic legislation.

Hungary in fact defaulted today...